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The merger with J.C. Flowers’ private equity group has completely fallen apart. Meanwhile, both market and legal conditions have changed dramatically since the deal was struck, leaving Sallie Mae (SLM) in a materially different operating position than before. The company stands at a cross-road.

The student loan business remains perfectly viable, especially for lenders holding loans on their books. It is a business which benefits from scale, which works in Sallie’s favor given their market leading position. However, return on equity for Federally guaranteed loans will decline due to legislative and market changes. On top of the decrease in subsidies, which has been widely reported, securitizing student loans, while still possible, is more expensive than in the past.

In addition, the sharp decline in SLM stock will force the company to renegotiate or otherwise deal with forward equity contracts which are now well underwater. While it seems that Sallie has the resources to deal with this, it is likely going to be significantly dilutive.

Finally, SLM probably needs to move toward an “A” bond rating to ensure adequate liquidity and to reduce interest expense.

SLM on its own again

As an independent firm, SLM’s core business model remains intact, although ROE will be compressed by legislative changes. The key elements to the College Cost Reduction and Access Act of 2007 legislation are as follows (from SLM’s 3rd quarter 10Q):

  • Reduces special allowance payments to for-profit lenders and not-for-profit lenders for both Stafford and Consolidation Loans disbursed after October 2, 2007 by 0.55 percentage points and 0.40 percentage points, respectively
  • Reduces special allowance payments to for-profit lenders and not-for-profit lenders for PLUS loans by 0.85 percentage points and 0.70 percentage points, respectively
  • For loans first disbursed after October 1, 2012, reduces default insurance to 95 percent of the unpaid principal of such loans
  • Eliminates Exceptional Performer designation (and the monetary benefit associated with it) effective October 1, 2007
  • Reduces default collections retention by guaranty agencies from 23 percent to 16 percent
  • Reduces the guaranty agency account maintenance fee from 0.10 percent to 0.06 percent

The Exceptional Performer designation allowed Sallie Mae to receive a 99% recovery on any defaulted loan. With that program being eliminated, SLM will be subject to 3% risk sharing. Probably the most important element is the reduction of payments on Stafford and PLUS loans. This will obviously impact SLM’s bottom line.

We agree with the company that the direct impact of the payment reduction will be mitigated by reduced competition over time. Many lesser players in the student loan market will be squeezed out by the reduced payments. SLM may indeed become an acquirer of smaller student loan originators. Given that the student loan business enjoys strong economies of scale, SLM’s ROE would improve with more market share.

Capital Requirements to Weigh on Shares
SLM faces significant capital needs:

  • We expect the company to hold more capital against government-backed loans.
  • The company has a stated desire to earn an “A” level rating, which will require better capital ratios than current. We believe improving their credit rating will be key to continued profitability.
  • The company has equity forward contracts which are well under water. The company is already renegotiating these contracts to avoid hitting triggers. According to Lehman Brothers analyst Bruce Harting, canceling the equity forwards will probably cost around $1.4 billion.

Because SLM’s loan portfolio remains solid (88% of SLM’s loan portfolio is FFELP and therefore carry a 97% Federal guarantee), we expect SLM will have little trouble raising capital. Recent equity infusions to more troubled financial institutions such as MBIA (MBI) reinforce this notion. However, we believe in order to achieve all three of the capital goals mentioned above, the company would have to raise between $2 and $2.5 billion. That vs. book value currently of $4.4 billion.

The company is currently trading at about 2x book value. If we estimate that book value would be impaired by $2 billion, the current share price would indicate a price/book ratio of 3.7x. While SLM has traded at much higher P/B ratios in the past, we would not expect SLM to trade higher than 3x book for the foreseeable future, given the reduced ROE and increased default risk within their portfolio.

We therefore choose not to buy the stock.

Note on SLM’s Future as an Independent

We believe the company will most likely seek a merger with a larger financial institution. Bank of America (BAC) and J.P. Morgan (JPM) had participated as minority partners in the original J.C. Flowers deal. Naturally one might think that either of these two banks could emerge as a strategic buyer of Sallie Mae. However, given current conditions, we believe most banks are more focused on preserving capital and/or improving their balance sheets. Banks with adequate capacity to make a strategic purchase in today’s market are most likely looking for more deeply discounted assets than SLM’s shares are currently. We see SLM remaining independent for the next 1-2 years, with a merger likely with a strategic buyer at some point after credit conditions overall improve.

Given the long time frame and highly uncertain price which a sale might fetch, we view the prospect of a merger in the future as a minor positive for stock price. It was not enough for us to alter our investment decision.

Position: Choose not to purchase.

Source: Sallie Mae at a Crossroads